Essays on Dynamic Macroeconomics

The macroeconomic theory of optimal fiscal and monetary policy based on the assumption of a ‘benevolent dictator’ has identified several key lessons which are thought to substantially improve the economic conditions of a nation (see Chari and Kehoe, 1999, Woodford, 2003): (i) Debt should be zero or negative in the long run, (ii) taxes on capital income should be zero in the long run or on average, and (iii) in the analysis of monetary policy, fiscal policy can largely be neglected. However, due to either distortions in the political process or market frictions beyond reach of policymakers, these optimal, welfare-enhancing policies are often not implemented as recommended by economic theory. The aim of this thesis is therefore twofold: First, to explain the gap between recommended and actually implemented policies and, second, to find mechanisms (or alternative policies) aimed at attenuating these deviations from optimality. Chapter 2 studieswelfare consequences of a soft borrowing constraint on sovereign debt which is modeled as a proportional fine per unit of debt exceeding some reference value. Debt is the result of myopic fiscal policy where the government is assumed to have a smaller discount factor than the private sector. In the absence of lump-sum taxation, debt reduces welfare. The chapter shows that the imposition of the soft borrowing constraint, which resembles features of the Stability and Growth Pact and which is taken into account by the policy maker when setting its instruments, prevents excessive borrowing. The constraint can be implemented such as to (i) control the long run level of debt, (ii) prevent debt accumulation, and (iii) induce debt consolidation. In all three cases the constraint enhances welfare and these gains outweigh the short run welfare losses of increasing the costs of using debt to smooth taxes over the business cycle by two orders of magnitude. Why do governments tax capital in face of the benchmark of standard economic theory that capital ought to be untaxed? Chapter 3 provides a model of fiscal policy with endogenous labour, bonds, and capital in order to account for the observation that worldwide taxes on capital remain far from zero. It introduces policy myopia into an otherwise standard framework of optimal fiscal policy where the government can tax labour and capital income and shows, analytically for the case of quasi-linear preferences and numerically for the case of CRRA preferences, that policy myopia leads to empirically realistic tax rates on capital. Moreover, it is shown that the tax rate on capital increases as myopia increases. Finally, the chapter analyzes the effects of policy myopia on the conduct of fiscal policy over the business cycle. Based on the theoretical analysis of Chapter 3, Chapter 4 presents empirical support for the hypothesis that higher political instability leads to an increase of the tax rate on capital income. The hypothesis is tested on a panel of annual observations for 13 OECD countries for the period 1964-1983. Themain finding is that an increase of the index of political instability by one standard deviation leads to an increase of the tax rate on capital by about 1.8 percentage points. This effect is statistically and economically significant and robust against alternative sets of regressors and measures of the dependent variable, outlier correction, and alternative estimation strategies. Chapter 5 (joint with Markus Kirchner) assesses the role of sovereign risk in explaining macroeconomic fluctuations in Turkey. We estimate two versions of a simple New Keynesian small open economy model on quarterly data for the period 1994Q3-2008Q2: A basic version and a version augmented by a default premium on government debt due to a perceived risk of sovereign debt default. Model comparisons clearly support the augmented version since it leads to stronger internal propagation and hence smaller shocks are required in order to reconcile the observed dynamics of nominal and real variables, leading to better forecasting performance. The results suggest that the augmented model may lead to a better understanding of macroeconomic fluctuations in emerging market economies that are subject to sovereign risk. In terms of policy implications, counterfactual experiments show that both more active monetary policy and stronger fiscal feedbacks from debt on taxes can lead to less volatile inflation and debt dynamics, but higher debt feedbacks on taxation additionally reduce expected default rates